Mutual funds come open or closed

Most of the mutual funds you’ll encounter are structured as open-end funds. This means there is no limit on the number of units they can distribute. Whenever an investor wants to buy in, the fund simply issues new units from its treasury at the current net asset value (NAV).In this way, the issuing of new units does not reduce the value of those currently outstanding (a process known technically as “dilution”).For example:
Suppose a fund has 100,000 units outstanding at an NAV of $10 each. Total assets under management are therefore $1 million.

If someone buys 1,000 new units at $10 each, the fund ends up with an additional $10,000 in assets from the cash acquired as a result of the sale (assuming no sales commissions are involved). So it would now have $1,010,000 in assets and 101,000 units outstanding. The NAV per unit would remain unchanged at $10.

Selling doesn’t affect NAV
An open-end fund will also redeem your units at the current NAV, usually with minimal notice. Again, there is no impact on the NAV of other unit holders when this happens; the purchase process is simply reversed.

r instance: If you wanted to redeem 500 units of the fund we used in the previous example, you would notify the company through your sales representative.

They would issue you a cheque for $5,000 (500 units times the current $10 NAV). The fund would then be left with assets of $995,000 and a total of 99,500 units outstanding. The NAV remains at $10.

Underlying assets define worth
The only way the NAV changes in an open-end fund is if the value of the underlying assets change.

Suppose, for example, that the fund received dividends of $30,000 from stocks it holds. Total assets of the fund therefore increase to $1,030,000. The 100,000 units outstanding now have a net asset value of $10.30 each — a 3 percent gain.

If the fund distributes those dividends to its unitholders by issuing cheques, then the net assets of the fund will again be worth $1,000,000 and the NAV will be back to $10. But you’ll have received a dividend of $0.30 per unit to compensate for the drop.

Next page: Closed-end funds limited

Closed-end funds limited
The overwhelming majority of mutual funds sold in Canada are the open-end type. But you may occasionally be offered an opportunity to buy into a closed-end fund.

These funds can sometimes offer unexpected profit potential. So you need to understand how they work and when to take advantage of them.

These funds issue a limited number of units. When the issue is fully subscribed, the offer is closed. No more units are made available at that time, although there may be additional offerings in the future.

Finding closed-end funds
This means if you want to buy units in a closed-end fund once the initial offering period is over, you have to find someone willing to sell them to you.

To facilitate the process, units in most closed-end funds are listed on a stock exchange, where they can be bought and sold more easily. You’ll find several closed-end funds traded on the Toronto Stock Exchange.

Examples include:

  • BPI Global Opportunities Fund
  • Canadian General Investments Fund
  • First Australia Prime Income Fund
  • New altamira Value Fund
  • Central Fund.

Market sets price
Unlike open-end funds, the NAV is not the determining factor in the selling price of a closed-end fund’s units (or shares). That price is set by the market. And often the market decides a closed-end fund should sell for less than its underlying NAV.

When that happens, a closed-end fund is said to be trading at a discount. Many Canadian closed-end funds trade at a substantial discount to their NAV — occasionally over 30 per cent and sometimes as high as 40 per cent.

When that happens, you are essentially buying a dollar’s worth of assets for 60 or 70 cents.

Adapted from Gordon Pape’s 2002 Buyer’s Guide to Mutual Funds, by Gordon Pape and Eric Kirzner, published by Prentice Hall Canada.